comparative analysis of some islamic financial techniques

7/31/2019 Comparative Analysis of Some Islamic Financial Techniques

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COMPARATIVE ECONOMICS OF SOME

ISLAMIC FINANCING TECHNIQUES

M. FAHIM KHAN*

There are several Islamic modes and techniques of financing as alternatives to interest

based financing. Each of these techniques has different economic implications for those who

provide the finance and for those who use the finance. This paper presents some economic

dimensions of the major Islamic financing techniques in a comparative perspective. The

comparative economics of these techniques has been discussed with respect to (a) their

distinctive economic features, (b) role of these features in economic decision making, and (c)

macro-economic consequences

It has been argued that the permissibility and availability of a variety of modes of

financing with different economic implications gives tremendous flexibility to individuals as well

as society in the management of their financial affairs.

1. INTRODUCTION

There are several Islamic modes of financing which serve as alternatives to interest

based financing. There is, however, divergence of views between theory and practice about the

order of preference of these modes of financing. The theoreticians are, generally, of the view

that profit/loss sharing should be the most widely prevailing mode of financing in the financial

system of Islam .1 Contemporary practice of Islamic banking, however, is overwhelmingly

dependent on the use of markup based techniques. Profit sharing is the least popular mode of

financing in most of the Islamic banks in the modern world .2 Some theoreticians have been

quite critical of this practice .3 This controversy can be understood and synthesized by analyzing

the economics of the various types of Islamic financing techniques.

Furthermore, each Islamic financing technique has different shades of economicimplications for the capital providers and capital users. Techniques differ according to the extent

of participation in management by the capital provider. They also have different implications on

uncertainty and variability of cost of the capital for the capital user. The economics of different

techniques needs to be studied for the capital provider and the capital user for theoretical as well

as practical purposes.

*Head, Research Division, Islamic Research and Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia.


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The differences in the nature of Islamic financing techniques have implications

for the economy at the macro level as well. Some techniques may be suitable for

achieving a certain set of macroeconomic objectives of the society while some others

may be suitable for other objectives. A comparative study of the macroeconomic

implications of these techniques, therefore, can hardly be overemphasized.

No systematic study has so far been done on the subject of comparative

economics of various Islamic financing techniques. The first ever reflection on the

comparative aspects perhaps appeared in the Report of the Council of Islamic Ideology,

Pakistan, on "Elimination of Interest from the Economy" [1980]. While evaluating the

techniques of Islamic financing as alternatives to interest based financing, the report

briefly discussed the comparative economics of these techniques. Keeping in view the

economics as well as other considerations, the Report concluded that the ideal

alternatives to interest in an Islamic economic system are profit/loss sharing and qard-

hasan. Though there might have been a lot of discussion during the deliberations of the

council on the comparative economics of these techniques, not much was included in the

report on the subject. Also, the main focus of the report was on the macro aspects. It did

not make any observations on the implications of these techniques on microeconomic

decision-making.

Later, several attempts were made to study the economics of profit loss sharing

(PLS) based system. These include Chaudhury [1974], Khan [1984], Khan [1985],

Habibi [1987] and Siddiqi [1988]. In all these studies PLS meant financing techniques

based on mudarabah and musharakah .Moreover, the objective of these studies was a

comparison with the interest based system only. These studies did not make any

comparison of the economics of PLS based techniques with those of other Islamic

techniques. However, some writings on the practice of the contemporary financial

institutions did make brief remarks on the comparative economics of various techniques.

These include Attia [1985], Mannan [1986] and Ahmad [1987], among others. But these

remarks were far from sufficient and hence the subject of comparative economics of

various techniques has generally been ignored.

This paper makes a very modest attempt to present, in more detail, some

economic dimensions of the major Islamic financing techniques in a comparative

perspective. It is only a first step towards making a more detailed analysis of the

comparative economics of various Islamic financing techniques.


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There are several possible financing techniques which conform to the Islamic

principles. Some of them were prevalent in the period of the Prophet (peace be upon

him) and the rightly guided Caliphs and these have been discussed in the fiqh literature.

Others have emerged recently to meet the contemporary financing requirements within

the light of the teachings of Islam.

There are five basic modes of financing. They are :

)i( Mudarabah

)ii( Musharakah

)iii( Ijara) Leasing(

)iv( Bay'-Salam

)v( Bay' - Murabahah (Bay' Ajil () or Mark up based Technique(

All Islamic financing techniques in theory and practice are direct or indirect

reflections of these five modes. Some techniques may combine features of two or more

of these modes. The present paper concentrates on these five basic techniques only .4

The comparative economics of these techniques may have two dimensions: (a)

their distinctive economic features, and (b) role of these features in economic decision

making and in shaping the features of the economy and its institutions.

The economics of these Islamic financing techniques is discussed, in the

following pages, in these two main dimensions.

2. ECONOMIC FEATURES OF ISLAMIC FINANCING TECHNIQUES

A lot of literature is available, mostly in Arabic, that explains in detail the legal

structure of the above mentioned financing techniques. The comparison of these

structures from economic point of view has not been a subject of any rigorous exercise

so far. The following distinctive features have been derived from review of the literature

on individual Islamic financing techniques.

2.1Nature of Financing

Financing techniques can be distinguished from the point of view of the nature of

financing involved in each techniques .Bay' salam and mark up based modes can be

regarded as debt creating modes of financing since financing in these two modes is in the


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nature of a debt. Here finance user stands obliged, to pay back the entire financing (or

the commodity as agreed in bay' salam .(The repayment by the finance user is, in fact,

predetermined in advance and hence becomes a sort of debt from the finance user's point

of view. On the other hand ,mudarabah and musharakah are non-debt creating modes in

the sense that the finance user is not obliged to pay back the total amount of financing.

To some extent ijara can also be regarded as a non-debt creating mode of financing. In

mudarabah and musharakah the finance user pays the cost of capital according to the

profits/loss that he makes out of the use of the financing whereas in ijara ,only the rent is

paid which may be a small part for any particular user of the total value of the asset.

The debt creating modes involve a debt burden on the user irrespective of how much he

benefits from the funds. Non-debt creating modes do not carry a debt burden. The user

pays according to the benefit he gets from the financing.

2.2Role of Finance Provider in the Management/Use of Funds

In bay' salam ,the finance providers have no role in the management of the funds

by the finance user. Once the finances have been handed over the finance user is free to

use the funds as he thinks best. In a sense mudarabah can also fall into this category

because the finance provider is not allowed to interfere in the management of the

enterprise in which his funds are being used. On the other hand ,musharakah gives an

opportunity to the finance provider to have a role in the management of the funds. In thecase of mark up based financing and lease-based financing the finance provider has full

control over the use of the funds since funds are deployed by the finance provider

himself .

2.3Risk Bearing by the Finance Provider

In both mudarabah and musharakah the entire capital invested by the finance

provider is at stake. The finance provider in mudarabah is responsible to bear all the

financial loss of the enterprise in which the finances were used. His entire finances are,

thus, at stake until the project is completed and the finances have been recovered. In the

case of musharakah the finance user will bear the financial loss in proportion to his

capital in the total investment of the enterprise. In this case too the entire capital of the

finance provider remains at stake until the project is completed and the finances have

been recovered. Almost similar is the case with leasing where the entire amount of

capital remains at stake as the capital owner is responsible for all the risks attached to the

life of the asset. The capital will be under risk until the asset successfully completes its

anticipated productive life. The risk bearing in bay' salam arises due to the uncertainty of


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the future prices of the commodities involved in the contract. In all of these four cases

i.e .mudarabah ,musharakah ,leasing and bay' salam ,the finance provider puts at stake

the entire amount of his capital as well as the opportunity cost of capital for the entire

period until the capital is received back.

In mark up based financing risk bearing is there but is less than that involved in

the above mentioned four techniques. The risk bearing in mark up is only up to the stage

when the goods are handed over to the capital user and not until receiving back the

capital as in the above mentioned techniques. Once the goods are handed over to the

finance user, all risk lies with him and the finance provider shares no risk till the

recovery of the finance.

Other things remaining the same ,the mark up based financing involves

minimum risk for the finance provider compared to other techniques because of the

following reasons.

)i)Finance provider does not bear risk for the entire period of the contract. The risk is

only for that period in which a spot sale is made and until the goods are

handed over to the client. For the remaining period of the contract, the

amount of financing plus the agreed mark up is in the nature of debt and

is risk-free. All other financing techniques carry the risk throughout theperiod of the contract.

)ii)Mark up based financing requires knowledge of only current prices of the goods

involved in determining the financing and a return on it. In the other

techniques, some anticipation or forecasting has to be made about values

of various variables involved in financing. This introduces an element of

risk to the extent that the anticipations or forecasting may not come true .

Bay' salam requires forecasting future market prices; leasing requires

forecasting the productive life of the asset and mudarabah and

musharakah require forecasting the profitability of the enterprise/activity

in which investment is to be made.


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2.4Uncertainty of the Rate of Return on Capital for Finance Provider

It has been mentioned above that all Islamic financing techniques involve risk

bearing by the finance provider. He has to bear the risk of loss of capital if he allows the

use of money in any of these modes. This means that any return that he may expect, ex-

ante, has some element of uncertainty. It is a common mistake to regard the trading

based and leasing based financing techniques as fixed return techniques. The

misunderstanding arises on the basis of the following arguments:

Mark up :Since the mark up is fixed and predetermined as a percentage of the capital

amount this techniques is considered to have a fixed rate of return. The mark up

itself is considered the fixed rate of return.

Leasing :Since rent is fixed and predetermined it is considered to imply a fixed rate of

return because renting an equipment worth US$ 100,000 at an annual rent of

US$ 10,000 means a 10% fixed rate of return on capital.

Bay' Salam :Since the quantity and price of the goods to be purchased from the finance

user are known and fixed in advance, the finance provider is assumed to have

fixed the rate of return in advance.

In all these cases the amount charged to the finance user is usually assumed also

to be the rate of return on capital. This is actually not the case. There are risks of losses

involved for the finance provider in all these techniques. In mark up based financing a

financier faces all risks normally involved in a trading activity such as goods getting

damaged during transportation, storage, etc. Furthermore, the finance provider also runs

the risk that the goods purchased for the finance user may not be finally accepted by the

finance user on account of quality or any other pretext. These risks thus keep the rate of

return uncertain until the goods have been finally handed over to the finance user.

In bay' salam financing though the price, quality and quantity of the goods to be

delivered to financier are predetermined, the actual rate of return remains unknown until

the goods in question are delivered to the buyer and he is able to dispose them of in the

market. His actual rate of return will depend on the actual prices at the time of disposing

of the goods compared with the prices paid for the goods and on the cost incurred in

disposing of the goods.


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The rent on an asset cannot be treated as a rate of return on capital invested in the

asset for the following reasons:

)i)The owner of the asset is uncertain about the total life of the asset. The asset can bring

earning only during its productive life. Also, the owner is not aware

what price the asset will fetch if he decides to dispose of the asset any

time during its productive life.

)ii)The owner of the asset is also uncertain about the extent to which the asset will

remain on lease during its productive life. On expiry of the contract with

the first lessee, the owner is uncertain about the time it will take him to

find the next lessee and the rent that will be agreed upon with him. Even

if the first lease continued it is quite possible that at any point of time the

lessee may demand revision in the rent due to any possible defect that

may adversely affect the productivity of the asset or the service for which

it was rented.

Mudarabah and musharakah generate risks primarily at the end of the finance

user. When it is a matter of financing only the finance owner has little role in the case of

mudarabah and may have only a secondary role in the case ofmusharakah in attempting

to control the risk of loss. On the other hand, leasing, mark up and bay' salam based

financing involves a risk that is not generated at the end of the finance user. In leasingthe risk is associated with the anticipated life of the asset and its continuous employment

on rent. In mark up based financing the risk is involved during the purchase of the

required goods and their handing over to the client. In bay' salam the risk occurs during

the receipt of goods from the client and their disposal in the market. In all of these three

modes the finance user has nothing to do with the risk being faced by the finance owner.

2.5Cost of Capital for the Finance User

The amount that the finance user ends up paying to the finance owner over and

above the original finance obtained is referred here as the cost of capital.

The cost of capital in case ofmudarabah ,musharakah ,and bay' salam remains

uncertain until the completion of the contract. The cost of capital in the case of leasing

and mark up based financing is predetermined and fixed .


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Thus, whereas the rate of return on capital is always supposed to be variable and

uncertain, it is possible for the cost of capital to be fixed and predetermined if leasing

and mark up modes are used.

2.6Relationship between the cost of capital and the rate of return on capital

In the case of mudarabah and musharakah the cost of capital and the rate of

return are explicitly the same. In the case of leasing, mark up and bay' salam based

financing, the cost of capital and the rate of return on capital, however, are divergent.

The case of mark up and leasing is straightforward. The finance user pays a fixed and

predetermined cost. In the case ofbay' salam ,the rate of return for the finance owner

(being dependent on the price that he is able to get in the market minus the cost of

marketing) may be different and unrelated to the cost that the finance user is obliged to

pay.


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Table 1

Comparative Features of Islamic Financing Techniques

TECHNIQUES

Techniques Mudarabah musharakah Ijara) Leasing( Bay'al Salam Murabahah)markup(

Features

Nature of financing Investment based Investment based Leasing based Combination of

debt and trading

Combination of debt

and trading

Role of the capital

provider in the

management of

funds

Nil Full control Full control on the

use of the finance

Nil Full control on the

use of the finance

Risk bearing by the

capital provider

i) To the full extent

of the capital as

well as of the

opportunity cost of

capital.

ii) For the entire

period of the

contract.

Same as in

Mudarabah


of the capital as well

as of the opportunity

cost of capital .

ii) Until the asset

completes its life or

is finally disposed of .

i) To the full

extent of the

capital as well as

of the

opportunity cost

of capital.

ii) Even after the

expiry of the

contract until the

goods are finally

disposed of.


of the capital .

ii) Only for a short

period until the goods

are purchased and

taken over by the

finance user.

Uncertainty of rate

of return

Complete

uncertainty

Complete

uncertainty

Complete uncertainty Complete

uncertainty

Uncertainty only for

a short period of the

contract

Cost of Capital Uncertain ex-ante Uncertain ex-ante Fixed and

predetermined

Uncertain ex-

ante

Fixed and

predetermined

Relationship of the

cost of capital and

the rate of return

on capital

Perfect correlation Perfect correlation Week Correlation No correlation Strong correlation

but not perfect

3. ECONOMIC ROLE OF ISLAMIC FINANCING TECHNIQUES

Islamic financing techniques can have different effects on decision-making of

economic agents as well as on the macroeconomic framework of the economy. Broadly

speaking, the economic role of various Islamic financing techniques may be studied

from the following aspects:

)i)Households' consumption - saving choice

)ii)Firm's investment decision making

)iii)Financial intermediation


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)iv)Macroeconomic implications

)v)General equilibrium at micro and macro level.

In the existing literature, there is very little discussion on the comparative aspects

of various Islamic financing techniques in the above mentioned dimensions. However,

they appear in the joint discussion of the economics of two Islamic financing

techniques, namely ,mudarabah and musharakah which are jointly referred to in the

literature as profit-sharing techniques. An attempt has been made in this section to infer

the comparative economics of various techniques from the limited discussion in the

literature on the economics of profit sharing techniques.

3.1Household Consumption - Savings Choice

Two Ph.D theses written in American universities have attempted to rigorously

show that profit sharing techniques make the lender ,5 i.e. saver, worse off .6 For example,

Rafi Khan [1983, pp. 112], tried to prove that irrespective of the profit-sharing ratio,

eliminating interest and introducing a pure profit-sharing system would inevitably make

the lenders worse off, compared to the interest-based system .7

Apart from the Shylockian flavor in this argument emphasizing the "lender's"

welfare without weighing it against the welfare of the other sections of the society8

, thereis a fundamental flaw in the methodology of arriving at such an argument. Such

arguments are always based on the assumption that profit-loss sharing system means

suppressing the interest rate to zero for the savers. In theory, as well as in practice, it has

been made clear that the Islamic financial system does not mean non-positive expected

rate of return on savings.

If we intend to make the comparison with the interest based system, we have to

ask the question, "will the banks working with Islamic financing techniques be able to

provide a risk-return package, on the average, better than, same, or worse than that in

interest based system?" It will be argued later in this section on financial intermediation

that the portfolio diversification and choice of various financing modes can enable an

Islamic bank to reduce its overall risk on its investment to an almost negligible level and

still make at least as much profit as the bank would have made by operating on the basis

of interest.

If a saver wants to use leasing or mark up or bay' salam modes to advance his

money to the user, then obviously the bank's risk-return package will be the floor for


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making any investment in these techniques. Lenders being small savers may not have the

expertise or know-how to grab a leasing or trade-business that may yield them a risk-

return package, on the average, better or at least equal to the profit-sharing based risk-

return package offered by the banks .

In the case of leasing and mark up based techniques, the welfare of the finance

user is expected to be lower than in profit sharing techniques (and may be close to what

it is in the interest based system) because these techniques imply fixed cost of capital for

the capital user in almost the same way as in the case of interest.

The user may be implied to be a little better off in the case of leasing based

financing compared to the trading based financing because of lesser repayment problems

in the former than in the latter in case the user suffers a loss in his project. In leasing-

based financing, if there is a loss the lessor will simply take his asset back and the lessee

will be obliged only to worry about the unpaid rent, if any. In the case of trading-based

financing, if there is a loss the finance user will have to worry about the repayment of the

entire capital plus the agreed upon mark up.

In bay' salam ,since the cost of capital is unrelated to the rate of return, the user

may end up worse off compared to profit sharing techniques. Also, in case of loss, the

user faces the same problem of repayment as in the case of the mark up basedtechniques.

Leasing, mark up and bay' salam based techniques, however, have one advantage

over mudarabah and musharakah from the point of view of the welfare of the finance

user. The former techniques can be utilized for meeting the household consumption

needs, whereas profit sharing techniques of mudarabah and musharakah cannot be

utilized for this purpose. In the profit sharing based system, those needing funds for

consumption purposes will find themselves in a difficult situation to get their needs

financed. This problem can be overcome in the leasing and mark up based financing.

The users of funds for consumption purposes thus may find themselves better off under

mark up, leasing and bay' salam modes than under mudarabah and musharakah modes.

3.2Firms' Investment Decision-Making

Profit-loss sharing techniques make the capital owner share the profit according

to actually realized productivity. Thus, the actually realized return on profit is the price

of capital which will determine its allocation.


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Modigliani and Miller (1980) have proved very convincingly in the context of

corporate finance that it is not the interest rate which determines the cut off point for the

selection of investment in an enterprise. According to their analysis, irrespective of

whether the source of financing is own savings or interest based loan or issuance of

common stocks, investment in an enterprise will be made only if the expected rate of

return in the enterprise is greater than or equal to the actual rate of return in the

comparable class of firms .9 This is a clear argument against those who believe that

interest plays an important role in the allocation of capital resources 10and that its

replacement by profit-sharing techniques may deprive the economy of the benefits of a

useful instrument.

Among PLS techniques ,musharakah may have an edge over mudarabah in the

sense that in musharakah ,capital owner has a right to interfere in the management and

hence can have some control over the problems created by informational asymmetry and

moral hazards .Mudarabah is void of any such control.

The role of leasing and mark up based techniques for an investment decision

may be close to the case of interest because as far as the capital user is concerned he

knows with certainty how much he will have to pay for the capital. But for the capital

owner, investment decision will depend on the rate of return on capital which will bedifferent from the cost of capital to be paid by the capital user, because the capital owner

has to make an allowance for uncertainties and other things already mentioned in section

2. Hence, there will be a divergence in the supply price and demand price of capital.

This divergence is a result of the fact that the capital user does not have to bear the

uncertainties that the capital owner does. It may also be noted that since an upper limit

on their profit is fixed by the rent or the mark up which are not related to the profitability

of the enterprise, these techniques may not have as primary a role in investment decision

making as profit-loss sharing techniques.

It has been argued that mudarabah financing will imply an infinitely elastic

demand for mudarabah funds .11 This is because the mudarib's stake in the enterprise

remains constant at the level of the opportunity cost of his labor irrespective of the total

financial investment of the finance provider in the enterprise, whereas the expected rate

of return is an increasing function of the financial investment. Every mudarib ,therefore,

would like to have as much investment as possible from the capital owner.


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This argument, though correct, has no economic significance unless we also

discuss the supply ofmudarabah financing and the simultaneity in the determination of

supply and demand. Supply of mudarabah financing will not be independent of the

profit sharing ratio for the supplier. Suppliers' profit sharing ratio will in turn depend on

the expected incomes and the risks involved in the project for which finance is being

demanded. While increased supply of funds may increase the income (depending on the

nature of the production function), it may also increase the risks (depending on the

nature of human capital of the entrepreneur using the finance). An equilibrium level of

profit sharing, thus, will be simultaneously determined at a level where supply and

demand are equal. The argument of infinitely elastic demand under mudarabah is a

result of the misconception that cost of capital under mudarabah is zero.

Cost of capital is the share in the profit that mudarib pays to the rabbul mal .A

utility maximizing mudarib will, of course, be motivated by the higher expected profits.

The increased supply of capital, however, will not come at a constant profit sharing ratio.

Profit sharing ratio will be an increasing function of the supply of capital because the

risks of giving higher amounts to a single mudarib may increase at an increasing rate.

This may simply be reflective of the diminishing marginal entrepreneurship of an

entrepreneur (compared to the diminishing marginal productivity of labor). On the other

hand, the productivity of the enterprise increases at a declining rate as more and more

capital is invested. It is obvious that a mudarib will demand capital to the extent wherehis total profit is maximum. This argument has been elaborated more rigorously in the

Appendix .

It may be noted that the upper limit on the supply of the capital will depend on

the asset that the mudarib is putting at stake in the business. If the mudarib is skilled or

professional labor, the capital owner may become willing to invest high amounts of

capital with one particular mudarib.

The same argument applies to musharakah .Since in musharakah the capital

user has his own capital as well, and since the capital owner has a right to interfere in the

management, the supply of capital may be relatively higher than that under mudarabah

for a given price of capital (i.e. for a given expected rate of return on capital.(

Since leasing and mark up based techniques imply a fixed cost of capital in the

same fashion as the interest rate, the nature and determinants of the demand for

investible resources may not be very different from the case of the interest based system.

Leasing based techniques may sometimes be to the advantage of the capital user


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compared to mark up based techniques because the capital user is responsible only for

the payment of the cost of capital and is not responsible for the capital goods itself.

Under certain other circumstances, mark up based financing may, however, be preferred

over leasing based financing as already discussed in the previous section.

Nadeem ul Haque and Abbas Mirakhor [1985] have argued that under profit

sharing techniques the level of investment will increase because elimination of interest

will allow the firms to invest up to a level where the marginal productivity of investment

becomes equal to one. Simple interpretation of the conclusion is that the investment will

continue to be undertaken until the return or profit on the last unit of money invested

becomes zero. Waqar M. Khan [1985] also shares this line of argument.

It is to be noted that investment decision-making requires that the marginal unit

of investment yields at least (1 + r), where r is the opportunity cost of capital. In the

interest based system, this decision rule means that the last unit of investment brings a

return at least equal to the rate of interest. The argument of Nadeem ul Haque and

Abbas Mirakhor, shared by Waqar M. Khan, implies that the profit sharing techniques

mean zero interest, therefore, investment can be done until its marginal productivity

becomes zero. This is not a correct line of argument.

Islamic injunctions do not imply that the opportunity cost of capital is zero. In anIslamic framework, a profit maximizing firm 12will continue investing until the marginal

productivity of capital becomes equal to the opportunity cost of capital. Without arguing

whether or not interest rate represents appropriately the opportunity cost of capital, it

requires no argument that when the capital is scarce, the opportunity cost of capital can

well be represented by the rate of return on alternate opportunities for investment of

comparable nature.

The presence of Islamic banks which can offer a positive rate of return on

deposits with negligible risk due to diversification of their portfolio produces a lower

limit to the opportunity cost of capital .13

It can easily be visualized that in the case of leasing based financing there may be

a mismatch between the demand for assets needed by entrepreneurs and assets that

capital owners can possibly supply, at least in the short run. This is so because of the

divergence in the cost of capital and the rate of return on capital. Hence, under

overwhelming use of leasing based financing it is possible that substantial amount of

capital may remain unemployed for considerable time and there can still be an excess


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demand for capital. The same may be true for overwhelming use of all such techniques

where the cost of capital and the return on capital do not converge and are interrelated.

3.3Financial Intermediation

Financial intermediation is an important institution of a modern economy. The

banks make economy more efficient. Islam promotes efficiency. The emphasis in the

Qur'an and Sunnah on avoiding waste and doing things in their best way is a simple

reflection of the fact that efficiency is a religious duty.

This section discusses the economic role of various Islamic financing techniques

in the banking system.

On the liabilities side, while dealing with depositors, the bank as well as

depositors, in principle, have only one option and that is the mudarabah technique

(though present practice may show some deviation from this principle). The bank will

promise the depositors to share, in a certain ratio, whatever profits it makes by using the

funds of the depositors. The depositor's share will then be distributed among all

depositors on a pro-rata basis. In case the bank undergoes a loss on the funds of the

depositors, then all depositors will bear the loss on a pro-rata basis.

Since the bank, as an institution of financial intermediation, invests only

depositors' funds, i.e., does not mix its own capital with the depositors' funds, the

musharakah techniques may not be applicable on the liabilities side. The same applies

to leasing and trading based (mark up as well as bay' muajjal (techniques because the

depositors neither participate in leasing nor in trading while depositing their savings with

the bank. The bank will ,however, have the option of offering packages to its depositors

with varying degrees of return and risk. This makes the banks working with Islamic

financing techniques more flexible in taking care of the preferences its depositors and

thus mobilizing their savings. All depositors will be exposed to some risk as they stand

liable to share the losses of the bank in case of such an eventuality.

Banks, however, have the ability to minimize the total risk by spreading their

investments to a large number of clients on the assets side. The larger the spread, other

things remaining the same, the lower the risk. In this process, obviously, the bank may

not be able to make high profits, yet there is no a priori reason that the bank will not be

able to make as much profit as they were making in an interest based system, particularly

in a capital scarce economy while keeping the risk at a negligible level.


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On the assets side, the scholars writing on the theory of Islamic banking argue in

favor ofmudarabah and musharakah as a suitable instrument for the banking system on

account of the following advantages:

)i)It is consistent with the financial intermediary nature of the bank. A bank simply

selects a suitable entrepreneur and invests its funds with the entrepreneur

and waits for the result, sharing of profits/losses.

)ii)It is capable of being utilized for varying periods of investment and with a

variety of entrepreneurs, small or large, allowing the bank a whole

spectrum of varying degrees of risk and return .

The disadvantages of this instrument for the banking system, however, are stated

to be the following:

)i)The concept of the mudarib being amin) trustworthy) is the corner stone of the

application of this financing technique. The fact that rabbul mal) bank in

this case) bears all the loss in mudarabah may result in moral hazards (a

behavior not consistent with the interest of the capital owner 14( on the

part of the users of the bank's funds.

)ii)The presence of moral hazard may not allow the bank to make largeinvestment with a single mudarib .This may affect the profitability of the

bank. The use of investment funds of the bank will depend, among other

factors, on the stake that the mudarib puts in. Unless a secondary market

is well functioning for mudarabah) through mudarabah/muqaradah

certificates/bonds), no single mudarib will be able to offer a business in

which he could have a very large stake on his own. The mudarabah

investments of banks, thus, will have to be low in the absence of

secondary markets.

The advantages ofmusharakah are the following:

)i)The possibility of moral hazard is reduced because the client would be making

his own investment as well. The problem of informational asymmetry too

would be reduced as the bank also has a right to interfere in the

management of the project in which it has invested.

)ii)The bank is able to invest in large concerns because the clients owning large

stakes in the business would not put the banks in a disadvantageous


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position in terms of risk. This may help in improving the bank's

profitability by enabling it to invest in larger and already established

concerns with high profitability and low risk.

)iii)It is possible to do musharakah for long as well as for short periods for

industrial as well as commercial, agricultural and service sectors .

Though musharakah financing gives the banks a right to participate in the

management of the funds, there remains a possibility that the bank simply waves its right

to interfere in the management and just performs the role of financial intermediary. All

economies have a shortage of capital, especially risk-bearing capital 15. Those in demand

for bank capital would try to behave in a way so as to have continued financial relations

with the bank. It should, therefore, not be difficult for the bank to select, from a large

number of finance seekers, such parties with which the bank may not feel the need to get

involved in the management. Hence, the bank can stick to its function of financial

intermediation only.

Leasing and leasing based financing would require a bank to deviate from its

basic character as a financial intermediator. It will have to involve itself in the following

activities:

)i)Purchasing an asset which requires certain marketing expertise and thenkeeping its ownership until the asset is disposed of (which sometime may

require storage capacity also.(

)ii)Maintenance of the asset and bearing of all costs associated with it in respect

of maintenance and replacement if it is deficient or fails to perform the

service for which it has been leased. This may often require some

knowledge and expertise about the assets under lease.

)iii)Disposing it of when the asset is not needed which requires not only bearing

all the risks resulting from price fluctuations but also some marketing

expertise.

All this will require the bank to engage in activities beyond financial

intermediation. Any leasing contract that will absolve the bank from all these activities

will fall into the category of financial leasing which is not permitted according to

shari'ah principles.

Since most of the deposits are short term and the profit on them is required to be

declared periodically say, annually or biannually, the banks will be compelled to depend


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on short term leasing. Short term leasing, however, will create extra burden on the

banks, because the frequency of purchasing, reselling and the maintenance work will be

higher as a result of shorter period of leasing contracts. Banks which are interested only

in doing financial intermediation may not like to engage in leasing based financing.

Commercial banks, therefore, should not use leasing based excessively if they

are interested in financial intermediation only. Leasing based finance, however, can

prove to be very useful in development financing. Leasing development finance

corporations already exist in practice.

One advantage of leasing based financing is that there is no informational

asymmetry involved as in the case of mudarabah/musharakah .If the bank is not

satisfied that its clients will declare correct profits, it can provide them financing through

leasing instruments/equipments/assets. The issue of moral hazard, however, will still be

there, as the clients may use the assets in an inefficient way and thus impose unnecessary

costs on the bank (who is the owner of the assets.(

Mark up based financing is an instrument similar to leasing based financing with

the difference that in this case the bank earns income from trading instead of leasing.

This financing technique has several advantages over leasing based financing. The risk

bearing period in trade financing is less than in the leasing based financing. The bankknows its profit as soon as the purchase/sale transaction is completed, even though the

bank's investment has not been fully recovered. This technique also makes the bank go

beyond the business of mere financial intermediation. It will have to take up the job of

being a trade-house or a trade company as well besides being a financial intermediary .16

Bay' salam also requires the bank to take up trading. But it is not as convenient to

the bank as the mark up based financing technique in terms of quickness of determining

the bank's profit (which ultimately determines the level of return on deposits). Another

disadvantage of the technique, which may make the bank not to prefer it, is that it does

not give the bank any objective basis to anticipate its profits. It will have to depend only

on speculation about future prices.

Before closing the discussion of the assets side, it may be instructive to note

clients' preferences as well.

In the initial stages of Islamization, when the entire economic structure has not

fully adjusted to the Islamic financial system and an appropriate commercial rapport has


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not been established between the clients and the bank, the profit-loss sharing financing

will usually be preferred by only such entrepreneurs who have low profitability or high

risk in their projects. The clients who have highly profitable or low risk projects will

prefer to use fixed cost financing techniques (i.e. leasing and mark up based) so that they

can reap most of the benefits of their projects. For reasons already explained, mark up

based financing will be preferable to leasing based financing beyond the PLS based

financing techniques.

Bay' salam may not be very much preferred by the clients because of the

possibility of being exploited by the bank in the process of speculating future prices.

Liquidity is one of the main concerns of commercial banks. The profit-loss

sharing techniques may limit at least the very short run liquidity of the banks unless

instruments are designed which have a secondary market as well .

Leasing based techniques create liquidity problems more than the profit-loss

sharing techniques because leasing is generally more profitable the lengthier the period

of leasing. The money invested in leasing business cannot be redeemed in short periods

without adversely affecting the profitability of the bank. However, if some instruments

can be designed on the basis of leasing having a secondary market also, then this may

not pose a liquidity problem.

Mark up based financing is potentially better from the liquidity point of view as

compared to the PLS or leasing based techniques .

Bay' salam may be better in terms of short-run liquidity as far as comparison

with leasing based financing is concerned, but it will still be inferior to the mark up

based techniques because of the time lag involved in the production of goods underlying

the bay' salam contract.

4. MACROECONOMIC IMPLICATIONS

The macroeconomic effects of various Islamic financing techniques are

discussed briefly under the following headings (on the basis of the microeconomic

effects mentioned in the previous sections and without going into macroeconomic

modelling.(

)i( Growth and development


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)ii( Inflation

)iii( Employment and elimination of poverty

)iv( Equity and income distribution

)v( Stability

4.1Growth and Development

Growth requires capital formation which in turn depends on the savings

channelled into the productive sectors of the economy. While interest may be an

instrument for mobilizing savings, it is not guaranteed that it will also channelize

resources to productive users and will not simply raise the present consumption of one

group of population at the cost of the savings of the other group. The emphasis of

Islamic financing techniques is to finance production and not consumption. Among the

techniques under consideration ,mudarabah and musharakah can be used for nothing but

to augment production and capital accumulation. Another contribution of these

techniques towards development is that they make all the capital in the economy to be

risk-bearing capital (a badly needed factor of production even in the developed

economies). They also create new entrepreneurs (Khan, 1986). These techniques,

particularly mudarabah ,look for entrepreneurs who may provide capital with some

positive earning. Hence, those who may not have decided to be entrepreneurs in an

interest based system, may decide to be so when a risk-bearing capital is available .17

The increased supply of risk bearing capital and new entrepreneurs may generate new

sources of growth in the economy not available in the interest based system. Leasing

can also be helpful for capital accumulation in the economy but commercial banks and

investment companies in the private sector may use this for the purpose of financing

consumption of durable goods as well. Leasing can best serve capital accumulation

mainly through development financing institutions in the public sector. Trading-based

techniques, both mark up and bay' salam based, are least conducive to capital

accumulation compared to the other techniques because they simply add value of the

trading service to the economy.

Since both mudarabah and musharakah can also be utilized in trading services

instead of production of goods and services, it is possible that these techniques also may

not necessarily turn out to be conducive to promoting formation of fixed assets and

infrastructural development. The liquidity considerations in PLS financing (on the

capital owner's as well as capital user's side) also may not allow the

mudarabah/musharakah funds to be deployed in long term investments. Similarly,

trading based techniques, being applicable only in trading, by definition, do not generate


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capital goods. They only generate trading services. Leasing based techniques, thus, may

be very much conducive to the formation of fixed assets and infrastructural

developments and in making long-term investment. Leasing based techniques can also

be utilized for financing such large projects as dams, roads, railways, airways, etc.

Special institutions, however, will be needed to operate leasing based development

financing .

4.2Inflation

Mudarabah and musharakah techniques can finance only production and cannot

finance consumption. These techniques thus may not be conducive to generating demand

pull inflation in the economy. Other techniques can be conducive to generating demand

pull inflation as they can be utilized for consumption financing as well. Leasing based

techniques (and to some extent mark up based techniques) can generate cost push

inflation because of the cost of capital is predetermined and may go up, for example, due

to excess demand for consumer durable goods without creating a corresponding increase

in output or productivity.

4.3Equity Aspect: Employment Generation and Elimination of Poverty

In the interest based system, human resources with no capital have no choice butto be wage labor. They cannot enter the entrepreneurial or business class because

business requires capital and they cannot afford benefiting from the capital of others for

reasons already discussed. If capital is scarce in the economy, there may not be any

employment opportunities for them for considerable time. Lack of capital may keep

most of the female population and a substantial part of the male population just out of the

labor force (i.e. neither working nor looking for work). If they had access to capital they

could be mobilized through having their own economic activities, even if it was self-

employment in petty trade, cottage industry, handicrafts etc. Implications of Islamic

financing techniques in this respect are the following:

Mudarabah is mainly for meeting the capital needs of people with

entrepreneurial capabilities but with no capital. Its utilization in trade can generate quick

income for such labor which will not only help them meet their own needs but can also

help them grow economically. A person having his own business, say, trade or a cottage

industry, has incentives as well as opportunities to save and accumulate capital and

hence improve his economic conditions. These incentives and chances are not available


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when he is working as wage labor. Since he does not have the opportunity to best utilize

his savings, he does not have as much incentive to save .

Musharakah can serve the same purpose for such class of population which may

be having some capital but their capital is too little to be used for a meaningful

enterprise. Availability of capital on musharakah basis will serve the same purpose that

mudarabah will do with labor without capital.

Leasing and trading based techniques can also be helpful. There is, however, a

fixed cost of capital involved in these techniques (rent or mark up) which low income

groups may not be able to afford in the initial phases of the enterprise .

4.4Equity Aspect: Reduction in Income and Wealth Inequalities

Mudarabah or musharakah techniques require the capital owner to share the

profits with the capital user. They provide equal opportunities to all entrepreneurs to

apply for financial resources from financial institutions. Their lack of own capital does

not come in the way of their securing finance (as in the case of interest based system

which requires creditworthiness and collaterals from the borrower) if their projects are

otherwise profitable and promise good returns on the capital. These techniques thus can

be a source of the circulation of wealth in the economy and hence provide betteropportunities also for the class of society without capital.

Secondly, since the capital owner shares the profit and so do the human

resources joining the mudarabah contract, there are greater chances of better distribution

of the benefits of growth between capital owners and labor than in the case where labor

gets a fixed wage and capital owner gets all the benefits of growth.

Leasing based techniques can also have similar effects. Human resources pay a

fixed amount of rent and they keep all benefits of growth. Since trading based financing

create debt obligations, which have to be fulfilled irrespective of what the human

resources can earn, such financing may not be as fruitful as mudarabah ,musharakah and

leasing based techniques in reducing income inequalities in economies where the labor

supply is abundant and capital is extremely scarce .

4.5Economic Stability


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It has been shown that application of the mudarabah/musharakah based system

on the liabilities side of the banks makes the banking system more stable than is the case

in the interest based system [Mohsin Khan, 1987]. This is because the liabilities of the

banks move in line with their assets and any shock on the asset side does not create an

immediate crisis for the banks to go off their equilibrium position in the short run .

Furthermore, the flexibility of prices to adjust to changes in the supply and

demand is crucial for ensuring stability of equilibrium. Capital pricing based on sharing

profits and losses not only is helpful to keep supply and demand of capital in equilibrium

but also to keep the supply and demand of entrepreneurs in equilibrium.

It has already been mentioned that interest rate may not fall into the set of factors

affecting investment decisions of entrepreneurs but that the rate of return does. Hence

profit sharing ratio can prove to be a more powerful policy variable to ensure stability

and growth than the interest rate. Several writers have discussed macroeconomic

stability in the context of the mudarabah/musharakah based system. None of them has

shown any serious reservations on the efficient use of monetary policy in ensuring

macroeconomic stability.

Mirakhor and Zaidi [1987] concluded in the framework of a general equilibrium

macro model that the financial system based on profit-sharing techniques enables theeconomy to efficiently absorb any shocks to the asset position. In an earlier paper,

Mohsin Khan [1987] had shown similar results in the framework of a short-run

macroeconomic model of a closed economy.

No attempt has so far been made to analyze the impact of leasing based or

trading based financing on the stability conditions.

Trading based, particularly mark up based, financing is close to interest based

financing as far as the capital user is concerned. Hence it may not yield the same results

that have been shown for the PLS based system. The effect of leasing based financing

on stability will require a different model than the one used so far to study stability under

the profit loss sharing system. The model for leasing based financing will have to take

into account the explicit divergence between the cost of capital and the return on capital

mentioned earlier. It will require extra variables to explain the divergence. No such

attempt has been made so far.


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5. GENERAL EQUILIBRIUM ANALYSIS

General equilibrium analysis in a micro framework is constrained by the failure

of existing methodologies to account for uncertainties inherent in the economic activities

of economic agents. The microeconomic framework for general equilibrium analysis,

therefore, has not generally been the subject of Islamic economists. Ali Khan [1981]

however, made an attempt to show the relevance of using the Arrow-Debreu type of

framework for describing the Islamic economic system and then using the Koopmans-

Montias framework to evaluate the outcome of the economy. The capital pricing on the

basis of Islamic financing techniques (particularly on PLS basis) can fit in this

framework, though definite conclusion may not be possible because of the

methodological constraints.

General equilibrium analysis in macroeconomic framework, however, is possible

and several attempts have already been made in this regard .18 All of these studies have

incorporated profit-loss sharing based financial system in their analysis. Most of these

studies have proved that the profit-loss sharing system is better than the interest based

system in terms of various macroeconomic dimensions. Certain studies, such as Habibi

[1987], do point out some negative aspects also of the introduction of PLS-based system

in the economy. Notwithstanding some conceptual misunderstanding of the Islamic

economic system, such studies also indicate in general an improved picture of theeconomy in a macroeconomic equilibrium framework.

No study so far has been made in the context of macroeconomic equilibrium to

investigate implications of the leasing based or the trading based financial system .

6. PRACTICAL CONSIDERATIONS

The discussion in sections 2 to 5 has been carried out on purely theoretical

grounds. The contemporary practice of Islamic banking has clearly shown that despite

various theoretical claims about the superiority of the musharakah and mudarabah for

commercial banking in an Islamic framework, the Islamic banks find mark up based

financing as most suitable for the practice of Islamic banking on the asset side .

Waqar M. Khan [1985] attempted to explain why the mudarabah/musharakah

based system may not be preferred vis-a-vis the interest based system. After establishing

the superiority of the system over the interest based system for lenders as well as

borrowers, he raised the question, why interest based system exists in competitive


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societies? The same question applies to the contemporary practice of Islamic banks. If

mudarabah/musharakah based techniques are generally better than leasing and trading

based techniques for Islamic banks, then why Islamic banks are insisting to continue

working on the mark up based technique and do not show their inclination to move

towards the mudarabah/musharakah-based system? Waqar M. Khan answered the

question in terms of the problems of informational asymmetry 19and the cost of

information involved in these techniques. He argued that (interest based) debt minimizes

the information cost and hence mudarabah/musharakah techniques having high

information cost turn out to be inefficient as compared to the interest based system. This

answer is not only far from being sufficient but it also does not address the root of the

problem .

Firstly, there is no such thing as minimization of information cost in debt

financing .20Debt financing, in fact, by-passes the need for information by requiring

collateral and creditworthiness to ensure the repayment of principal plus fixed and

predetermined interest [Green, 1987]. The issue of information cost is an issue of

mudarabah /musharakah only and it has to be dealt with within this system by

comparing the benefits with the costs of the system as a whole .

The issue of information cost, in fact, has been exaggerated by Waqar M. Khan

out of all proportion .21

The problem is certainly not as significant in a bank-clientrelationship where the financing is sought and provided for business and commercial

enterprise and where hardly any client would like to have only one-time relationship

with the bank (and hence cheat the bank by hiding the correct information about his

business). Where more than one-time relationship is required and where there is

competition in the market to bid for scarce (and risk-bearing) capital, the problem of

losing on account of informational asymmetry cannot be as important as presented by

Waqar M. Khan. The issue of informational asymmetry is present in all market

transactions but the market can take care of such asymmetries. In almost all market

transactions, some deadweight loss can be ascribed to some degrees of informational

asymmetry involved in the transactions, but the transactions exist in the market because

of the benefits involved in the transactions. The absence of mudarabah/musharakah

from the market on account of information asymmetry could be acceptable if Waqar M.

Khan had shown that the cost of information associated with these techniques would be

higher than the benefits obtained from the superiority of the system that Waqar Khan

himself established. In the framework of the need of a continued bank-client

relationship for commercial purposes and in the framework of a competitive demand for

bank finances, the problem of informational asymmetry is much less than what we find


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in the marketing of several other goods. The fact that market for used cars exists should

be enough to demonstrate believe that mere informational asymmetry cannot be a

hindrance in the existence of mudarabah/musharakah techniques in the financial

market .22

Certain conventions and institutions in a market will always be present to limit

the scope for fraud due to information asymmetry, particularly when credit rating and

client relations become important in repetitive transactions. Institutions and conventions

can be developed if they do not already exist to restrict gains from fraud .23 There is also

a possibility of developing an appropriate incentive system to induce an agent to disclose

all information. Furthermore, there are sectors that have reasonably developed markets

and where information asymmetry is almost non-existent. The corporate sector in

developed economies is an example. Why the mudarabah/musharakah system with all

its superiorities over debt financing, explained and rigorously proved by Waqar M. Khan

himself, could not find its way in these sectors still remains to be answered even if

Khan's thesis of informational asymmetry is accepted. There is, thus, a need to find an

explanation beyond the issue of informational asymmetry.

7. CONCLUSION

Elimination of interest from an Islamic economy will not leave any vacuum forthe financial dealings in the society. Islam provides a set of techniques that can be

utilized to meet all financing needs. These techniques have different shades of

application. The availability of this variety of shades in the financial techniques provides

flexibility to the economic agents to manage their financial dealings .

In general, comparative analysis of various Islamic financing techniques clearly

reveals that popular use of PLS based methods of financing will yield favourable results

both at micro and macro levels not only in comparison with interest based financing but

also in comparison with other Islamic financing techniques. It, however, does not mean

that the other financing techniques are less important and need to be discarded. They

have their own uses and applications both at micro and macro levels. They not only

complement the profit-loss sharing methods but also provide flexibility of choice to meet

the specific needs of different sectors and different economic agents in the society.

Notwithstanding the superiority of PLS based methods, the reluctance of the

contemporary Islamic financial institutions to use them in their practice of Islamic

financing is curious. The phenomenon of asymmetry of information leading to the so


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called "dead weight loss in terms of information cost" cannot explain this reluctance.

This is something that needs to be looked into beyond the issue of informational

asymmetry.


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APPENDIX

DEMAND FORMUDARABAHCAPITAL

Consider an entrepreneur demanding capital for an enterprise. With Y as

output/income, K as capital and L as labor, we write the production function as:

Y = F (K, L) ---------------- (1.(

Since labor and capital are sharing the income of the project and hence do not

impose fixed costs ,this production function also represents net income function for the

project.

Assuming that the entrepreneur is the only labor in the project and hence the

labor component is fixed, we can write the production function as:

Y = F (K) ---------------- (2.(

As a typical production function we assume that this production function has

declining marginal productivity of capital, i.e. F ) K) > 0, F" (K ( 0.

The function, in other words, has the following form:Y

To be copied - curve is there

K

Fig (1(


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On the other hand the provider of capital expects to receive certain return on his

capital. His expected return, of course, will be directly related with the total amount he

invests. In the very simplest form, this relationship can be a linear relationship of the

type:

C = rK ---------------- (3.(

Where C is total return that the provider of capital expects to earn on his capital

and `r' is based on his own utility function.

In the interest based framework, the provider of capital demands `r' from the user

of his capital. In the Islamic framework, the provider of capital cannot demand `r'. It can

only fix a share in the income or profit of the project.

Let this share be called `a '. Since income, i.e. Y, is not fixed and varies at

different levels of K, the profit-sharing ratio becomes a function of the amount of capital.

Using equations (3) and (2) we can write:

-(4)---------------F(K)

rK=

Y

C=a 1

This equation shows, that profit sharing ratio will vary as more and more capital

is invested because C is increasing at a constant rate and Y is increasing at a declining

rate.

This fact can be more clearly seen in the following diagram.


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Y, C


K

Fig (2(

The curve A is the production function representing equation (2). The line B

shows the total return expected by the capital owner at different amounts of capital to be

provided by him. This is a straight line representing equation (3.(

Two things are clear from Fig (2). Firstly, the income sharing ratio a' is different

at different levels of K. The value of a' can be observed at any level of K as a ratio of

the corresponding value at line B to the ratio of the corresponding value at curve A.

It should be noted that beyond a certain level of K, the income sharing ratio starts

increasing until it reaches a level equal to 1.o. This will occur at Ko.

Secondly, it will not be in the interest of the entrepreneur to demand any amount

of capital from the capital owner. A profit maximizing entrepreneur will demand onlythat much capital which will allow him to retain maximum profit. In terms of Figure (2),

he would demand that much amount of capital against which the distance between curve

A and Line B is maximum. (The distance between curve A and Line B measures the

income to entrepreneur after paying the share of capital owner from the income of the

enterprise.(

Hence, the assertion that under the profit-sharing system there will be infinite

demand for capital is not validper se.


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The argument can be taken a step further.

Under the profit-sharing arrangement, the supply schedule for capital funds may

not be a linear function as shown by equation (3). Since capital owner bears all losses of

an enterprise, capital owner would not like to give as much capital as demanded by the

entrepreneur at a constant rate of return `r'. Giving all his money to one mudarib would

mean putting all his eggs in one basket. He would like to spread his investment among

different enterprises, unless an entrepreneur is willing to offer a return higher than `r' -

higher enough to compensate for the risk of putting more capital in one enterprise.

Thus a higher supply of capital for the same mudarib would mean a higher

income-sharing ratio with the same mudarib .In other words, we will have to rewrite

equation (3) as:

C = g (K) ---------------- (4(

with g' (K ( 0

g" (K ( 0

The profit maximizing entrepreneur then faces the following profit function:

P = Y - C

R = F (K) - g(K(

Optimum demand for capital by mudarib will be for that level of K where,

F ) K) = g ) K(

Once again this proves that the demand for mudarabah capital will not be infinite

when F" (K ( O and g ) K ( O.

This can be shown in the following diagram as well:

Y, C



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K

Fig (3(

Curve A represents the production function as shown by equation (2). Curve B

represents the capital supply schedule of the capital owner as shown by equation (4.(

Profit maximizing entrepreneur will demand K where the distance between A

curve and B curve is maximum reflecting the maximum profit left with the mudarib after

paying the income-share of the capital owner.

NOTES

1. See M.N. Siddiqi (1973), p.9.2. See Ausaf Ahmad (1987), pp.45-47.

3. See Ziauddin Ahmad (1989.(

4. Qard hasan) a pure loan without any return or interest) is also a mode of financing but

has been excluded from the discussion as this mode is not considered to have a

substantial role in the financial market of an economy.

5. It may be noted that in case of PLS and leasing and mark up based techniques the

finance provider cannot be termed as lender in its true sense.

6. See Habibi (1987) and Rafi Khan (1984.(

7. The argument of Rafi Khan (1984) is the following which is based on the framework

borrowed from Branson (1979.(

A consumer who has surplus funds now has to decide how much to be kept in

money form and how much to be kept in a risk-bearing asset. In a PLS based

system, a consumer will face a positive relationship between risk and rate of

return. If he needs a higher return, he will have to face higher risk. This has been

assumed to have a linear relationship as shown by the line OK in the diagram [a].

The curve AA is the indifference curve showing the preferences of a saver

between risk and expected rate of return. The tangency of AA and OK lines at


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point E shows the situation where the saver (and hence the lender) would be

enjoying maximum welfare. He will be investing OM* of his wealth and will be

earning a rate of return R.*

Rafi Khan then presents the interest based situation and argues that the budget

line will be at the position rK instead of OK as shown in diagram 4(b). The line

rK is shown to start at a point much higher than the starting point of OK. OK

starts at origin, implying no-risk, no-return situation. rK starts higher than the

origin because of the positive rate of interest without risk bearing. Since the

budget line in the case of interest based system is higher than in the case of PLS-

system, the consumer will be at a higher indifference curve BB (enjoying

increased welfare) in the interest based system compared to that in the PLS-

based system as shown by the indifference curve AA.


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Space for Diagram - to be copied please

The basic flaw in this analysis is simple. No doubt, in Islamic economy there is

"no-risk no-return" but this adage, in no way implies that the budget line in theabove framework must start from zero, the point far below the starting point of

the interest based budget line. It has been argued in the section on financial

intermediation that the ability of banking institutions to diversify their

investment/asset portfolios can help them minimize their risk to an almost

negligible level. This will obviously put a restraint on their profit-making

capacity, but there is no a priori reason to believe why their profits (which in

turn will determine the return on deposits) will force them to pay a return much

less than the interest rate in the alternative framework. On the contrary, there are

a priori reasons to believe that the rate of return on savings deposits in the PLS

system may be higher than that in the interest based system. Hence there is no a

priori justification that the budget line in the PLS system in the above framework

will be below that of the interest based system and will have a higher slope than

that of the interest based system. Hence the banks while anticipating higher

profits cannot give the depositors a very low rate of return. The budget line under

the PLS based system will primarily depend on the opportunity cost of capital

(productivity of capital in alternative opportunities). The PLS based budget line

thus will have the following features compared to the interest-based budget line.


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)i)Budget line under PLS based system will not start on Y-axis (as in case of the

interest-based system), though the starting point may be approaching Y-

axis as closely as possible.

)ii)The starting point in PLS-based system, most likely, will be higher than that

in the interest- based system because it will have to compensate for two

elements - (a) productivity of capital and) b) risk-bearing .24 Thus a most

realistic representation of PLS-based system in the Branson framework

will be as follows:

Space for Diagram - to be copied please


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The lender's welfare, thus, will most likely be at a higher level in the PLS based system

as compared to that in the interest based system .

8. All such attempts which have proved worsening of lender's welfare could not find out

what would happen to borrower's welfare. See Habibi [1987] and Rafi Khan

[1984.[

9. See Modigliani and Miller [1980] p,30 and 31.

10. See also M. Anas Zarqa [1983.[

11. See Habibi [1987 .[

12. A profit maximizing firm, under competitive conditions, will simply be minimizing

its costs and this situation can directly be inferred from textual sources to be

desirable in the Islamic economy. Prohibition ofisrafrequires the resources to

be judiciously used which means minimization of cost as well.

13. See M. Fahim Khan [1987.[

14. Moral Hazard is a term initially used in insurance business and basically refers to a

behavior where an agent acts against the interest of his principal, or where an

agent behaves inefficiently as a result of the nature of his contract.

15. See Albach [1978.[

16. Though contemporary practice has designed some instruments based on mark up

financing which do not require the bank to involve in actual trading, the shari'ah

validity of such instruments is questioned in some circles.

17. See detailed discussion of this aspect of PLS techniques in M. Fahim Khan [1986].Also see Siddiqi [1973, 1983] and Mannan [1984.[

18. Anwar [1987], Choudhury and Azizur Rehman [1983], Nadir Habibi [1987] and

Mirakhor and Zaidi [1988 .[

19. Informational asymmetry refers to a situation where two contracting parties do not

share the same information. In mudarabah ,the principal or the capital provider

has no right to interfere in the enterprise. The agent or capital user may not

provide complete information about the business operations and about profits

and losses. The principal does not have as much access to the information about

the enterprise as the agent has. The agent thus, may get involved in what has

been referred to as "moral hazard" (see note 14 above .(

20. Waqar M. Khan could talk about minimizing of the cost of information even within

debt financing by assuming that no collaterals are required under debt financing.

Such an assumption is wholly unrealistic and hence is not relevant for

understanding practical considerations for the existence of the interest based

system vis-a-vis the PLS based system.

21. Waqar M. Khan's thesis is not quite suitable for understanding the Islamic interest

free system. The model he has selected for the analysis has simplified and


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modified the Islamic financial system so much that it hardly remains relevant for

representing an Islamic system. Some of his simplifying assumptions are as

follows:

)a)The model assumes a situation where there can be no loss in investment.

Considering financing in such a system takes away all the novel

peculiarities of the PLS techniques. The distinctive feature of PLS system

(that may not be found in any other system based on profit sharing) is

that PLS techniques force the capital owner to bear the loss in proportion

to his share in the total capital of a project. If this peculiarity is assumed

away, then the PLS system is hardly left with anything to be compared

with.

)b)The model also assumes a situation where no collateral is required in the

interest based system. Furthermore, it is assumed that in the interest

based system, the lender is willing to accept a payment less than the rate

of interest, if the borrower makes a profit less than the interest rate. Also,

it is implicitly assumed that all interest based loans go to productive

activity and cannot be used for consumption purpose. These are certainly

not the features of the interest based system. They rather reflect the

features of the PLS system. Such marked deviations from realities about

the systems considered make his results quite doubtful from the point of

view of understanding the two systems.22. The informational asymmetry in the marketing of used cars is much more than what

can be assumed in PLS techniques because sale of a used car is one time

relationship between the seller and the buyer. Furthermore, the seller is absolved

of any obligations if any defect is detected in the car after the sale, whereas the

bank's client will be responsible if any defect is found in his account. For further

discussion on the market of used cars, see Akerlof [1970.[

23. See David Flath [1980.[

24. See Nadeem ul Haque and Abbas Mirakhor [1985]. Also see Waqar M. Khan [1985.[

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